The economics of licensing contracts – Nature Bioentrepreneur

In the August edition of the Nature Biotechnology journal, as part of their ‘bioentrepreneur – from bench to boardroom’ section, there is a great article on licensing contracts( Mason, Savva & Scholtes. 2008). For a newbie to the area it provides a great introduction; explaining why biotech/ pharma are different compared to other industries (where goods are sold in a one off director monetary transaction) and secondly the authors dive into the strategy behind licensing contracts.

A couple of licensing concepts and strategies that I would like to highlight are:

Asymmetric information – This occurs when one party knows more about the product , giving them a significant negotiating advantage. In most cases it is the licensor knows more about the drug than the licensee and is a reason why outright sales are not commonplace in biotech product development. Obviously the price that is offered for the product reflects the risk associated with not having this information. Furthermore this unbalance of information can be countered by challenging the licensor to shift payments to further on in the product’s development – hence signaling the quality of invention, preventing unethical behaviour.Further down the development track when/if re-negotiations are employed, the balance of this information can be flipped to the licensee who has been responsible for taking forward the drug (and hence generating new information about the drug) since the inception of the licensing deal.

Unlike a direct one off transaction, multiple payment structures are available , permitting the cost of the license to be transferred over the product’s life cycle. And allows a compromise between parties to be reached such that the risk is sufficiently shared between them. Different payment structures include milestone fees, annual fees, fixed royalties and volume dependent royalties.

RISK – How risk is assessed depends on the size of the party/organisation/company. Larger companies can likely absorb a product failure due to their expansive pipelines so typically take on more of the risk.

Royalties can limit the incentive for late stage investment by the licensee by eroding profitability, resulting in license termination. This can be avoided by structuring license payments that follow increasing revenues.

If termination is inevitable take back clauses allow the licensor to the reclaim asset.

Portfolio effects – Large companies (typically the licensee) commonly have multiple leads some which may be within same market. What happens when one becomes more profitable? It can shift the focus of development efforts and halt development. However annual fees, penalties and due diligence can counteract this.